Fannie Mae 2002 Annual Report Download - page 33

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FANNIE MAE 2002 ANNUAL REPORT
creates affordable homeownership and housing opportunities
through innovative partnerships and initiatives that build
healthy, vibrant communities across the United States. It is
a separate, private, nonprofit organization that we do not
consolidate, but is supported solely by Fannie Mae. We
expect the 2001 contribution to the Fannie Mae Foundation
to reduce the Foundation’s need for contributions over the
next several years. We acquired the shares through open
market purchases and contributed them to the Foundation
in the first quarter of 2002.
Purchased Options Expense
Purchased options expense includes the change in the fair value of the
time value of purchased options in accordance with FAS 133. The change
in the fair value of the time value of purchased options will vary from
period to period with changes in interest rates, market pricing of options,
and our derivative activity.
Our reported income results for 2002 were unfavorably
affected by $4.545 billion in purchased options expense
related to changes in the time value of purchased options,
significantly more than the $37 million expense recorded in
2001. The substantial increase in expense during 2002 was
caused by an increase in the average notional balance of caps
and swaptions, two types of purchased options we commonly
use to manage interest rate risk, to $287 billion in 2002 from
$154 billion in 2001, coupled with a sharp decline in interest
rates that resulted in a decrease in time value. Under FAS
133, we are not allowed to recognize in earnings changes
in the intrinsic value of some of these options, which, in
combination with the fair value of options in our mortgage
assets and callable debt, would have more than offset the
decrease in the time value of these options during 2002. Prior
to the adoption of FAS 133 on January 1, 2001, we amortized
premiums on purchased options into interest expense on a
straight-line basis. In 2000, we recorded $231 million in
purchased options amortization expense that is included
as a component of net interest income.
During the fourth quarter of 2002, we refined our
methodology for estimating the initial time value of interest
rate caps at the date of purchase and prospectively adopted
a preferred method that resulted in a $282 million pre-tax
reduction in purchased options expense and increased our
diluted EPS for 2002 by $.18. Under our previous valuation
method, we treated the entire premium paid on purchased
“at-the-money” caps as time value with no allocation to
intrinsic value. Our new methodology allocates the initial
purchase price to reflect the value of individual caplets, some
of which are above the strike rate of the cap, which results in
a higher intrinsic value and corresponding lower time value
at the date of purchase. This approach is more consistent
with our estimation of time value subsequent to the initial
purchase date. This change does not affect the total expense
that will be recorded in our income statement over the life of
our caps and has no effect on our non-GAAP core business
earnings measure.
Debt Extinguishments
Fannie Mae strategically repurchases or calls debt securities and related
interest rate swaps on a regular basis as part of our interest rate risk
management efforts and to reduce future debt costs. We record gains
and losses on debt extinguishments in this category.
We recognized a pre-tax loss of $710 million in 2002 from
the call and repurchase of debt, compared with a pre-tax loss
of $524 million in 2001. Market conditions during 2002 and
2001 made it advantageous for us to repurchase $8 billion
and $9 billion, respectively, of debt securities that were
trading at historically wide spreads to other fixed-income
securities. We also called over $174 billion of high-coupon
debt securities and notional principal of interest rate swaps in
2002 and $173 billion in 2001. The weighted-average cost of
redeemed debt and interest rate swaps in 2002 and 2001 was
5.36 percent and 6.23 percent, respectively. During 2000,
we repurchased or called $18 billion in debt securities and
notional principal of interest rate swaps carrying a weighted-
average cost of 7.10 percent and recognized a gain of
$49 million.
During the second quarter of 2002, we adopted Financial
Accounting Standard No. 145, Rescission of FASB Statements
No. 4, 44, and 64, Amendment of FASB Statement No. 13, and
Technical Corrections (FAS 145). This standard eliminates the
extraordinary treatment of the gains and losses on our debt
repurchases because debt extinguishment is a normal and
recurring component of our interest rate risk management
strategy. For comparative purposes, we have reclassified all
prior periods to conform to the current presentation.
Income Taxes
The provision for federal income taxes, including tax related
to the cumulative effect of change in accounting principle,
decreased to $1.429 billion in 2002 from $2.131 billion in
2001. The 2002 decrease in tax expense was primarily related
to the tax benefit recorded on the increased purchased
options expense. Our tax provision totaled $1.583 billion in
2000. The combined effect of our low-income housing tax
credits and the reduction in our 2002 pre-tax income from
purchased options expense caused our effective tax rate on
reported net income to decline to 24 percent from 27 percent
in 2001 and 26 percent in 2000. Our effective tax rate based
on our core business earnings, which is adjusted for the
impact of FAS 133 on our purchased options, was 27 percent