Fannie Mae 2001 Annual Report Download - page 67

Fannie Mae enters into pay-fixed interest rate swaps and
swaptions, as well as interest rate caps to change the variable-
rate cash flow exposure on its short-term Discount Notes
and long-term variable-rate debt to fixed-rate cash flows.
Under the swap agreements, Fannie Mae receives variable
interest payments and makes fixed interest payments,
thereby effectively creating fixed-rate debt. Fannie Mae also
purchases swaptions that give it the option to enter into a
pay-fixed, receive variable interest rate swap at a future date.
Under interest rate cap agreements, Fannie Mae reduces the
variability of cash flows on its variable-rate debt by
purchasing the right to receive cash if interest rates rise
above a specified level.
Fannie Mae continually monitors changes in interest rates
and identifies interest rate exposures that may adversely
impact expected future cash flows on its mortgage and debt
portfolios. Fannie Mae uses analytical techniques, including
cash flow sensitivity analysis, to estimate the expected impact
of changes in interest rates on Fannie Mae’s future cash
flows. Fannie Mae did not discontinue any cash flow hedges
during the year because it was no longer probable that the
hedged debt would be issued. Fannie Mae had no open
positions for hedging the forecasted issuance of long-term
debt at December 31, 2001.
Financial Statement Impact
Consistent with FAS 133, Fannie Mae records changes in the
fair value of derivatives used as cash flow hedges in AOCI to
the extent they are perfectly effective hedges. Fair value gains
or losses in AOCI are amortized into the income statement
and are reflected as either a reduction or increase in interest
expense over the life of the hedged item. The income or
expense associated with derivatives has historically been
recognized in interest expense as an adjustment to the
effective cost on the hedged debt. Fannie Mae estimates it
will amortize approximately $4.7 billion out of AOCI and
into interest expense during the next 12 months. The
amortization of the $4.7 billion into interest expense from
AOCI does not produce a different result in the income
statement versus prior periods. Actual results in 2002 will
likely differ from the amortization estimate because actual
swap yields during 2002 will change from the swap yield
curve assumptions at December 31, 2001.
The reconciliation below reflects the change in AOCI, net of
taxes, during the year ended December 31, 2001 associated
with FAS 133:
Year Ended
December 31,
Dollars in millions 2001
Transition adjustment to adopt
FAS 133, January 1, 2001 . . . . . . . . . . . . . . . . . . . . . . . . . $(3,972)
Losses on cash flow hedges, net . . . . . . . . . . . . . . . . . . . . . . . (5,530)
Less: reclassifications to earnings, net . . . . . . . . . . . . . . . . . . 2,143
Balance at December 31, 2001 . . . . . . . . . . . . . . . . . . . . . . . . $(7,359)
If there is any hedge ineffectiveness or derivatives do not
qualify as cash flow hedges, Fannie Mae records the
ineffective portion in the fee and other income (expense)
line item on the income statement. For the year ended
December 31, 2001, fee and other income (expense) includes
a pre-tax loss of $3 million related to the ineffective portion
of cash flow hedges.
Fannie Mae includes only changes in the intrinsic value of
pay-fixed swaptions and interest rate caps in its assessment of
hedge effectiveness. Therefore, Fannie Mae excludes changes
in the time value of these contracts from the assessment of
hedge effectiveness and recognizes them as purchased options
expense on the income statement. For the year ended
December 31, 2001, Fannie Mae recorded a pre-tax loss of
$34 million in purchased options expense for the change in
time value of options designated as cash flow hedges.
Fair Value Hedges
Objectives and Context
Fannie Mae employs fair value hedges to preserve its
mortgage-to-debt interest spreads when there is a decrease
in interest rates by converting its fixed-rate debt to variable-
rate debt. A decline in interest rates increases the risk of
mortgage assets repricing at lower yields while fixed-rate
debt remains at above-market costs. Management limits the
interest rate risk inherent in its fixed-rate debt instruments
by using fair value hedges to convert its fixed-rate debt to
variable-rate debt.
Risk Management Strategies and Policies
Fannie Mae enters into various types of derivative
instruments, such as receive-fixed interest rate swaps and
swaptions, to convert its fixed-rate debt to floating-rate debt
and preserve its mortgage-to-debt interest spreads when
interest rates decrease. Under receive-fixed interest rate
swaps, Fannie Mae receives fixed interest payments and
makes variable interest payments, thereby creating floating-
rate debt. Receive-fixed swaptions give Fannie Mae the
option to enter into an interest rate swap at a future date
{ 65 } Fannie Mae 2001 Annual Report