Fannie Mae 2002 Annual Report Download - page 64

62 FANNIE MAE 2002 ANNUAL REPORT
•Rather than issuing a 10-year noncallable fixed-rate
note, we could issue short-term debt and enter into
a 10-year interest rate swap with a highly rated
counterparty. The derivative counterparty would
pay a floating rate of interest to us on the swap that
we would use to pay the interest expense on the
short-term debt, which we would continue to reissue
periodically. We would pay the counterparty a fixed
rate of interest on the swap, thus achieving the
economics of a 10-year fixed-rate note issue.
•Similarly, instead of issuing a 10-year fixed-rate note
callable after three years, we could issue a 3-year note
and enter into a pay-fixed swaption that would have
the same economics as a 10-year callable note. If we
want to extend the debt beyond three years, the
swaption would give us the option to enter into a swap
agreement where we would pay a fixed rate of interest
to the derivative counterparty over the remaining
7-year period.
The ability to either issue debt securities or modify debt
through the use of derivatives increases our funding
flexibility and potentially reduces our overall funding costs.
We may be able to obtain a specific funding structure using
derivatives that we cannot obtain through the issuance of
callable debt. In addition, it can be less expensive to use the
mix of debt securities and derivatives to achieve a given
funding objective. We generally use the method that provides
the lowest funding costs and desired flexibility.
Table 23 gives an example of equivalent funding alternatives
for a mortgage purchase with funding derived solely from
debt securities versus funding with a blend of debt securities
and derivatives. As illustrated by Table 23, we can achieve
similar economic results by funding our mortgage purchases
with either debt securities or a combination of debt securities
and derivatives.
TABLE 23: EQUIVALENT DEBT AND DERIVATIVE
FUNDING
Fund With:1
Debt Securities Debt Securities and Derivatives
Percentage Type of Debt Percentage Type of Debt
10% Short-term debt 10% Short-term debt
15 3-year noncallable debt 15 3-year noncallable debt
25 10-year noncallable debt 25 Short-term debt plus
10-year swap
50 10-year callable 50 3-year noncallable debt
in 3 years plus pay-fixed swaption
100% 100%
1This example indicates the possible funding mix and does not represent how an actual purchase would
necessarily be funded.
Fannie Mae also uses derivatives to hedge against fluctuations in
interest rates on planned debt issuances. The hedging of
anticipated debt issuances enables us to maintain an orderly
and cost-effective debt issuance schedule so we can fund daily
loan purchase commitments without significantly increasing
our interest rate risk or changing the spread of our funding
costs versus other market interest rates. Most of the
mortgages that Fannie Mae commits to purchase are for a
future settlement date, typically two weeks to three months
into the future. Fannie Mae would be exposed to additional
interest rate risk from changes in market rates prior to
settlement if we did not issue debt at the time of the
commitment or did not lock in an interest rate by hedging
the anticipated debt issuance. By hedging anticipated debt
issuance versus issuing debt at the time of commitment, we
are able to issue debt in larger size and on a regular schedule
so that liquidity is enhanced while our relative cost of funds
is reduced.
Fannie Mae uses derivatives to hedge foreign currency exposure.
We occasionally issue debt in a foreign currency. Because
all of our assets are denominated in U.S. dollars, we enter
into currency swaps to effectively convert the foreign-
denominated debt into U.S. dollar-denominated debt.
By swapping out of foreign currencies completely at the
time of the debt issue, we minimize our exposure to any
currency risk. Our foreign-denominated debt represents
less than one percent of total debt outstanding.
Primary Types of Derivatives Used
Table 24 summarizes the primary derivative instruments
Fannie Mae uses along with the key hedging strategies we
employ to manage our various interest rate risk exposures.