Fannie Mae 2004 Annual Report Download - page 101

guaranty losses; and (iv) the assessment of variable interest entities. We evaluate our critical accounting
estimates and judgments required by our policies on an ongoing basis and update as necessary based on
changing conditions. We describe our most significant accounting policies in “Notes to Consolidated Financial
Statements—Note 2, Summary of Significant Accounting Policies.”
Fair Value of Financial Instruments
Valuation of financial instruments is a critical component of our consolidated financial statements because a
significant portion of our assets and liabilities are recorded at estimated fair value. Our estimate of fair value
of these assets and liabilities may have a major impact on our consolidated net income or stockholders’ equity.
The principal assets and liabilities that we record at fair value, and the manner in which changes in that fair
value affect our net income or stockholders’ equity, are:
• Derivatives initiated for risk management purposes and mortgage commitments, both of which are
recorded in the consolidated balance sheets at fair value with changes in fair value recognized through
earnings;
• Guaranty assets and guaranty obligations, which are recorded in the consolidated balance sheets at fair
value at the inception of the guaranty and amortized through earnings;
• Investments in securities that are classified as either trading or AFS, which are recorded in the
consolidated balance sheets at fair value with the change in fair value of trading securities recognized
through earnings and the change in fair value of AFS securities recorded in AOCI;
• Loans included in our portfolio that are classified as held for sale, which are recorded in the consolidated
balance sheets at the lower of cost or market with changes in the fair value (not to exceed the cost basis
of these loans) recorded through earnings; and
• Retained interests in securitizations and guaranty fee buy-ups on Fannie Mae MBS, which are recorded in
the consolidated balance sheets at fair value with unrealized gains and losses recorded in AOCI.
Fair value is defined as the amount at which a financial instrument could be exchanged in a current transaction
between willing unrelated parties, other than in a forced or liquidation sale. We determine the fair value of
these assets and obligations based on our judgment of appropriate valuation methods and assumptions. The
degree of management judgment involved in determining the fair value of a financial instrument depends on
the availability and reliability of relevant market data, such as quoted market prices. Financial instruments that
are actively traded and have quoted market prices or readily available market data require minimal judgment
in determining fair value. When observable market prices and data are not readily available or do not exist,
management must make fair value estimates based on assumptions and judgments. In these cases, even minor
changes in management’s assumptions could result in significant changes in our estimate of fair value. These
changes could increase or decrease the value of our assets, liabilities, stockholders’ equity and net income. We
estimate fair values using the following practices:
• We use actual, observable market prices or market prices obtained from multiple third parties. Pricing
information obtained from third parties is internally validated for reasonableness prior to use in the
consolidated financial statements.
• Where observable market prices are not readily available, we estimate the fair value using market data
and model-based interpolations using standard models that are widely accepted within the industry. Market
data includes prices of instruments with similar maturities and characteristics, duration, interest rate yield
curves, measures of volatility and prepayment rates.
• If market data used to estimate fair value as described above is not available, we estimate fair value using
internally developed models that employ techniques such as a discounted cash flow approach. These
models include market-based assumptions that are also derived from internally developed models for
prepayment speeds, default rates and severity.
Of all assets and liabilities recorded at fair value in our consolidated balance sheet as of December 31, 2004,
96% were valued using observable market prices or market price data obtained from third parties, 3% were
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