Fannie Mae 2002 Annual Report Download - page 36

34 FANNIE MAE 2002 ANNUAL REPORT
While the reconciling items to derive our core business
earnings are significant components in understanding and
assessing our reported results and financial performance,
investors may not be able to directly discern the underlying
economic impact of our interest rate risk management
strategies without our core business results. We believe
our core business earnings measures help to improve
transparency and enhance investors’ understanding of
our operations, as well as facilitate trend analysis.
The specific FAS 133 related adjustments affecting
our Portfolio Investment business that we identify in
Table 4 include:
(a) Purchased options amortization expense: This amount
represents the straight-line amortization of
purchased options premiums over the original
expected life of the options that we include in our
core net interest income. We include this amount in
core business earnings instead of recording changes
in the time value of purchased options because it is
more consistent with the accounting for the
embedded options in our callable debt and the vast
majority of our mortgages.
(b) Purchased options expense: This amount, which is
recorded in our income statement under purchased
options expense, represents changes in the fair value
of the time value of purchased options recorded in
accordance with FAS 133. We exclude this amount
from our core business earnings measure because the
period-to-period fluctuations in the time value
portion of our options does not reflect the economics
of our current risk management strategy, which
generally is to hold our purchased options to maturity
or exercise date. Consequently, we do not expect to
realize the period-to-period fluctuations in time
value.
(c) Cumulative after-tax gain upon adoption of FAS 133:
This non-recurring amount represents the one-time
transition recorded upon the adoption of FAS 133 on
January 1, 2001. We exclude the transition gain from
core business earnings because it relates to unrealized
gains on purchased options that were recorded when
we adopted FAS 133.
(d) Provision for federal income taxes adjustment: Represents
the net federal income tax effect of core business
earnings adjustments based on the applicable federal
income tax rate of 35 percent.
Core business earnings does not exclude any other
accounting effects related to the application of FAS 133 or
any other non-FAS 133 related adjustments. The guaranty
fee income that we allocate to the Credit Guaranty business
for managing the credit risk on mortgage-related assets held
by the Portfolio Investment business is offset by a
corresponding guaranty fee expense allocation to the
Portfolio Investment business in our line of business results.
Thus, there is no inter-segment elimination adjustment
between our total line of business guaranty fee income and
our reported guaranty fee income. We allocate transaction
fees received for structuring and facilitating securities
transactions for our customers primarily to our Portfolio
Investment business. We allocate technology-related fees
received for providing Desktop Underwriter and other
online services and fees received for providing credit
enhancement alternatives to our customers primarily
to our Credit Guaranty business.
As discussed in “MD&A—Risk Management—Interest Rate
Risk—Derivative Instruments,” we use various funding
alternatives, including option-based derivative instruments,
that produce similar economic results to manage interest rate
risk and protect against the prepayment option in mortgages.
The adjustments made to our Portfolio Investment business
to derive core business earnings provide consistent
accounting treatment for purchased options and the
embedded option in callable debt securities—economically
equivalent funding transactions—by allocating the cost of
purchased options on a straight-line basis over the original
expected life of the option in a manner similar to our
accounting for options in callable debt. We calculate the
original expected life of “European” options based on the
exercise date. We calculate the original expected life of
“American” options based on the expected life at the time
the option is purchased. There is a difference in the original
expected lives of European and American options because
European options are exercisable only on one specific date in
the future, while American options are exercisable any time
after a specific future date. The actual life of an American
option may differ from our original expected life because of
movements in interest rates subsequent to the exercise date
that may affect the value and benefit of exercising the option
at a given time.
We can protect our net interest margin against changes
in interest rates by either issuing callable debt to fund the
purchase of mortgages or using a combination of callable
debt, purchased options, and noncallable debt. We generally
use the method that helps us achieve our desired funding
flexibility and lowest cost. If interest rates fall and our
mortgages prepay, we have the option of retiring callable