Fannie Mae 2004 Annual Report Download - page 104

As mortgage rates increase, expected prepayment rates generally decrease, which slows the amortization of
cost basis adjustments. Conversely, as mortgage rates decrease, expected prepayment rates generally increase,
which accelerates the amortization of cost basis adjustments.
Allowance for Loan Losses and Reserve for Guaranty Losses
The allowance for loan losses and the reserve for guaranty losses represent our estimate of probable credit
losses arising from loans classified as held for investment in our mortgage portfolio as well as loans that back
mortgage-related securities we guarantee. We use the same methodology to determine our allowance for loan
losses and our reserve for guaranty losses as the relevant factors affecting credit risk are the same. Credit risk
is the risk of loss to future earnings or future cash flows that may result from the failure of a borrower to
make the payments required by his or her mortgage loan. We are exposed to credit risk because we own
mortgage loans and have guaranteed to MBS trusts that we will supplement mortgage loan collections as
required to permit timely payment of principal and interest on the related Fannie Mae MBS. We strive to
mitigate our credit risk by, among other things, working with lender servicers, monitoring loan-to-value ratios
and requiring mortgage insurance. See “Risk Management—Credit Risk Management” below for further
discussion of how we manage credit risk.
We employ a systematic methodology to determine our best estimate of incurred credit losses. This includes
aggregating homogeneous loans into pools based on similar risk attributes, using models to measure historical
default and loss experience on the homogeneous loan populations, evaluating larger multifamily loans
individually for impairment, monitoring observable data for key trends, as well as documenting the results of
our estimation process.
Determining the adequacy of the allowance for loan losses and the reserve for guaranty losses is complex and
requires significant judgment by management about the effect of matters that are inherently uncertain. When
appropriate, our methodology involves grouping loans into pools or cohorts based on similar risk categories
including origination year, loan-to-value ratios, loan product types and loan ratings. We use internally
developed models that consider relevant factors historically affecting loan collectibility, such as default rates,
severity of loss rates and adverse situations that may have occurred affecting the borrowers’ ability to repay.
Management also applies judgment in considering factors that have occurred but are not yet reflected in the
loss factors, such as the estimated value of the underlying collateral, other recoveries and external and
economic factors. The methodology and the amount of our allowance for loan losses and reserve for guaranty
losses on Fannie Mae MBS are reviewed and approved on a quarterly basis by our Allowance for Loan Loss
Oversight Committee, which is a committee chaired by the Chief Risk Officer and comprised of senior
management from the Single-Family and HCD businesses, the Chief Risk Office and the finance organization.
We adjust our estimate of the allowance for loan losses and reserve for guaranty losses based on
period-to-period fluctuations in loss experience, economic conditions in areas of geographic concentration and
profile of mortgage characteristics. Using different assumptions about default rates, severity and estimated
deterioration in borrowers’ financial condition than those used in estimating our allowance for loan losses and
reserve for guaranty losses could have a material effect on our net income.
Given that a minimal change in any factor listed above that is used for calculation purposes would have a
significant impact to the allowance and reserve liability and these factors have significant interdependencies,
we do not believe a sensitivity analysis isolating one factor is realistic. Therefore, the following example
illustrates the impact to the allowance and reserve liability given changes to multiple assumptions used for
these factors. For example, a natural disaster, such as a hurricane, might have an adverse impact on net income
and our allowance for loan losses and reserve for guaranty losses. The damage to the properties that serve as
collateral for the mortgages held in our portfolio and the mortgages underlying our mortgage-backed securities
could increase our exposure to credit risk if the damage to the properties is not covered by hazard insurance.
Our estimate of probable credit losses related to a hurricane would involve considerable judgment and
assumptions about the extent of the property damage, the impact on borrower default rates, the value of the
collateral underlying the loans and the amount of insurance recoveries. In the case of Hurricanes Katrina and
Rita in 2005, we preliminarily estimated default rates, severity of loss rates, value of the underlying collateral,
and other potential recoveries. As more information became available, we determined that the property damage
99