Fannie Mae 2004 Annual Report Download - page 102

valued using market data or standard modeling techniques with market inputs and 1% were valued using
internally developed models with inputs based on management’s judgment of market-based assumptions rather
than market observations.
Our determination of fair value also affects our accounting for other financial instruments. Certain cost basis
adjustments that affect the value of our financial instruments are based on fair value. Master servicing assets
and liabilities are recorded at the lower of cost or fair value. Impairment of certain assets requires an
assessment of fair value and the judgment of management to determine whether the asset is other than
temporarily impaired. In the case of an other than temporarily impaired security, impairment would negatively
affect the recorded value of the security and reduce our net income.
Sensitivity Analysis for Risk Management Derivatives
Of the financial instruments discussed above, changes in the fair value of our derivatives have the most
significant impact on net income. The table below provides a sensitivity analysis to illustrate the potential
impact that changes in the fair value of our derivatives would have on our net income. The two key variables
used in the determination of the fair value of our derivatives are the level of interest rates and the implied
volatility of interest rates. Implied volatility represents the market’s expectation of potential changes in interest
rates. It is not uncommon for interest rates and implied volatility to change significantly from period to period.
These changes could affect the valuation of our derivatives in the consolidated balance sheets and the resulting
gain or loss that would be recorded in our net income in the consolidated statements of income. Table 10
below shows the potential effect on the estimated fair value of our derivatives and on our net income of (i) a
10% change in implied volatility, (ii) a 100 basis point increase in interest rates and (iii) a 50 basis point
decrease in interest rates as of December 31, 2004 and 2003. Our analysis is based on these interest rate
changes because we believe they reflect reasonably possible outcomes as of December 31, 2004.
Table 10: Risk Management Derivative Fair Value Sensitivity Analysis
2004 2003 2004 2003
Estimated Fair Value
of Derivatives
(1)
Percentage Effect
of Change in
Estimated Fair
Value of
Derivatives
On Reported Net
Income
(2)
(Restated) (Restated)
(Dollars in millions)
Derivative assets at fair value . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 6,527 $ 7,058
Derivative liabilities at fair value . . . . . . . . . . . . . . . . . . . . . . . . . . 1,095 3,070
Net derivative assets at fair value. . . . . . . . . . . . . . . . . . . . . . . . . . $ 5,432 $ 3,988
Effect of:
(3)
+10% change in implied volatility . . . . . . . . . . . . . . . . . . . . . . . $ 973 $ 1,173 13% 9%
⫺10% change in implied volatility . . . . . . . . . . . . . . . . . . . . . . . (956) (1,173) (13) (9)
+100 bps change in rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 8,525 $14,211 112% 114%
⫺50 bps change in rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (3,150) (6,675) (41) (54)
(1)
Excludes commitments accounted for as derivatives.
(2)
Reflects after-tax effect of derivative market value adjustment based on applicable federal income tax rate of 35%.
(3)
Calculated based on an instantaneous change in volatility or interest rate.
Amortization of Cost Basis Adjustments on Mortgage Loans and Mortgage-Related Securities
We amortize cost basis adjustments on mortgage loans and mortgage-related securities through earnings using
the interest method, applying a constant effective yield. Cost basis adjustments include premiums, discounts
and other cost basis adjustments on mortgage loans or mortgage-related securities that are generally incurred
at the time of acquisition, which we historically referred to as “deferred price adjustments.” When we buy
mortgage loans or mortgage-related securities, we may not pay the seller the exact amount of the unpaid
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