Fannie Mae 2004 Annual Report Download - page 115

Derivatives Fair Value Losses, Net
We record all derivatives as either assets or liabilities in the consolidated balance sheets at estimated fair value
and recognize changes in fair value in our consolidated statements of income. Changes in the fair value of our
derivatives, including mortgage commitments, resulted in losses of $12.3 billion, $6.3 billion and $12.9 billion
in 2004, 2003 and 2002, respectively.
Because we did not qualify for hedge accounting during the reported periods, we changed the timing of the
recognition of the derivative gains and losses in our consolidated statements of income and the classification
of net contractual interest expense accruals on interest rate swaps. Prior to the restatement, we had pre-tax
cumulative deferred net derivative losses reported in AOCI and cumulative debt basis adjustments totaling
$13.5 billion as of June 30, 2004 and $15.8 billion and $16.6 billion as December 31, 2003 and December 31,
2002, respectively. Had we qualified for hedge accounting, the cumulative deferred losses would have been
amortized into income in future periods, resulting in a decrease in our future net income. The restatement
shifted the recognition of the cumulative deferred losses on our derivatives to net income from AOCI for the
restatement period and eliminated the cumulative debt basis adjustments. In addition, the net contractual
interest expense accruals on interest rate swaps, which were previously recorded in our income statement as a
component of interest expense, are included in “Derivative fair value losses, net.”
To fully understand the derivatives fair value gains and losses recognized in our consolidated statements of
income, it is important to examine the gains and losses in the context of our overall interest rate risk
management objectives and strategy, including the economic objective in our use of various types of derivative
instruments, the factors that drive changes in the fair value of our derivatives, how these factors affect changes
in the fair value of other assets and liabilities, and the differences in accounting for our derivatives and other
financial instruments.
While we use debt instruments as the primary means to fund our mortgage investments and manage our
interest rate risk exposure, we supplement our issuance of debt with interest rate-related derivatives to manage
the prepayment and duration risk inherent in our mortgage investments. As an example, by combining a pay-
fixed swap with short-term variable-rate debt, we can achieve the economic effect of converting short-term
variable-rate debt into long-term fixed-rate debt. By combining a pay-fixed swaption with short-term variable-
rate debt, we can achieve the economic effect of converting short-term variable-rate debt into long-term
callable debt. The cost of derivatives used in our management of interest rate risk is an inherent part of the
cost of funding and hedging our mortgage investments and is economically similar to the interest expense that
we recognize on the debt we issue to fund our mortgage investments. However, because we do not apply
hedge accounting to our derivatives, the fair value gains or losses on our derivatives, including the periodic net
contractual interest expense accruals on our swaps, are reported as “Derivatives fair value losses, net” in our
consolidated statements of income rather than as interest expense.
Our derivatives consist primarily of over-the-counter (“OTC”) contracts and commitments to purchase and sell
mortgage assets that are valued using a variety of valuation models. The valuation model that we select to
estimate the fair value of our derivatives requires assumptions and inputs, such as market prices, yield curves
and measures of interest rate volatility, which often require judgment. Accordingly, we have identified the
estimation of the fair value of our derivatives as a critical accounting policy, which we discuss further in
“Critical Accounting Policies and Estimates—Fair Value of Financial Instruments—Sensitivity Analysis for
Risk Management Derivatives” and “Notes to Consolidated Financial Statements—Note 19, Fair Value of
Financial Instruments.” We also discuss the primary factors affecting changes in the fair value of our
derivatives. These factors include the following:
•Changes in the level of interest rates: Because our derivatives predominately consist of pay-fixed swaps,
we typically report losses in fair value when interest rates decrease. As part of our economic hedging
strategy, these derivatives, in combination with our debt issuances, are intended to offset changes in the
fair value of our mortgage assets, which tend to increase in value when interest rates decrease.
•Implied interest rate volatility: We purchase option-based derivatives to economically hedge the
embedded prepayment option in our mortgage investments. A key variable in estimating the fair value of
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