Fannie Mae 2002 Annual Report Download - page 56

54 FANNIE MAE 2002 ANNUAL REPORT
Fannie Mae’s purchased options portfolio currently includes
swaptions and caps, which are discussed in more detail under
“MD&A—Risk Management—Interest Rate Risk
Management—Derivative Instruments.” The total fair value
for purchased options consists of the time value plus the
intrinsic value. Under FAS 133, the mark-to-market on the
time value component of our purchased options flows
through our reported earnings. The time value of purchased
options will vary from period to period with changes in
interest rates, expected interest rate volatility, and derivative
activity. However, the total expense included in earnings over
the original expected life of an option will generally equal the
initial option premium paid. Since adopting FAS 133, we
have reported significant fluctuations in our reported net
income because of unrealized fluctuations in the estimated
time value of purchased options. As a result of the declining
interest rate environment in 2002 and the increase in the
notional value of our purchased options, we recorded
$4.545 billion in purchased options expense in 2002,
compared with $37 million in 2001.
Our methodology for valuing purchased options is based
on commonly used market conventions and assumptions.
We obtain quoted market prices for a benchmark set of
interest rate options, which include caps and swaptions.
Based on these quoted market prices, we apply our valuation
model, which effectively utilizes these prices to estimate the
fair value of our purchased options. We then allocate the
fair value of our purchased options into the time value
and intrinsic value components. Because the benchmark
securities are only a subset of the purchased options that we
hold, the estimation of time value is not exact and can vary
depending on the market source and methodology used.
This variation could have a material effect on our reported
net income. Hence, we believe our estimate of the time
value component of purchased options is a “critical
accounting estimate.”
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. 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. We now allocate the purchase
price to reflect the value of individual caplets, some of which
are above the strike rate of the cap. This approach, which is
more consistent with our estimation of time value subsequent
to the initial purchase date, results in a higher intrinsic value
and lower time value at the date of purchase. We adopted this
preferred valuation method prospectively on caps purchased
after third quarter 2002, which resulted in a $282 million
pre-tax reduction in our 2002 purchased options expense.
The change has no effect on the total expense that will be
recorded in our income statement over the life of our caps
and no effect on our core business earnings.
To gauge the potential sensitivity of changes in the estimated
time value of our purchased options, we recalculated our
estimates based on plus and minus changes of 5 percent and
10 percent in the time value portion of our outstanding
purchased options at December 31, 2002 and 2001. An
increase in the estimated time value of our purchased options
would reduce our purchased options expense and increase
our reported net income and stockholders’ equity, while
a decrease in the estimated time value would increase
purchased options expense and reduce our reported net
income and stockholders’ equity. These changes are
generally greater than changes we have observed historically
in our valuation process. Table 20 shows the potential effect
on our 2002 and 2001 reported results from these changes in
time value. There would be no effect on our 2000 results as
we adopted FAS 133 on January 1, 2001.
TABLE 20: IMPACT OF CHANGES IN THE TIME VALUE OF PURCHASED OPTIONS
Percentage of Percentage of Total
Change in Fair Value Adjustment Reported Net Income1Stockholders’ Equity
Dollars in millions 2002 2001 2000 2002 2001 2000 2002 2001 2000
10% change in time value . . . . . . . . . . . $543 $493 NA 8% 5% NA 2% 2% NA
5% change in time value . . . . . . . . . . . . 271 246 NA 43NA 11NA
1Reflects after-tax effect of time value adjustment based on applicable federal income tax rate of 35 percent.
Table 20 reveals that a plus or minus change of 10 percent in
the time value portion of our purchased options at December
31, 2002 and 2001 would change our reported net income by
8 percent and 5 percent, respectively. A plus or minus
change of 5 percent in the time value portion of our
purchased options at December 31, 2002 and 2001 would
change our reported net income by approximately 4 percent
and 3 percent, respectively. Changing the time value portion
of our purchased options by 10 percent or 5 percent would
change our total stockholders’ equity by approximately