Fannie Mae 2004 Annual Report Download - page 137

manage or hedge the impact of changes in mortgage-to-debt OAS after we purchase mortgage assets,
other than through asset monitoring and disposition.
•Change in the Guaranty Business Fair Value. As described more fully in “Notes to Consolidated
Financial Statements—Note 19, Fair Value of Financial Instruments,” we calculate the estimated fair value
of our existing guaranty business based on the difference between the estimated fair value of the guaranty
fees we expect to receive and the estimated fair value of the guaranty obligations we assume. The fair
value of both our guaranty assets and our guaranty obligations is highly sensitive to changes in interest
rates and credit quality. Changes in interest rates can result in significant periodic fluctuations in the fair
value of our net assets. For example, as interest rates decline, the expected prepayment rate on fixed-rate
mortgages increases, which lowers the fair value of our existing guaranty business. We do not believe,
however, that periodic changes in fair value are the best indication of the long-term value of our guaranty
business because they do not take into account future guaranty business activity. Based on our historical
experience, we expect that the guaranty fee income generated from future business activity will largely
replace any guaranty fee income lost as a result of mortgage prepayments. Accordingly, we do not
actively manage or hedge expected changes in the fair value of our guaranty business related to changes
in interest rates. To assess the value of our underlying guaranty business, we focus primarily on changes
in the fair value of our guaranty business resulting from business growth, changes in the credit quality of
existing guaranty arrangements and changes in anticipated future credit performance.
RISK MANAGEMENT
Overview
Our businesses expose us to the following four major categories of risk:
•Credit Risk. Credit risk is the risk of financial loss resulting from the failure of a borrower or
institutional counterparty to honor its contractual obligations to us and exists primarily in our mortgage
credit book of business and derivatives portfolio.
•Market Risk. Market risk represents the exposure to potential changes in the market value of our net
assets from changes in prevailing market conditions. A significant market risk we face and actively
manage is interest rate risk—the risk of changes in our long-term earnings or in the value of our net assets
due to changes in interest rates.
•Operational Risk. Operational risk relates to the risk of loss resulting from inadequate or failed internal
processes, people or systems, or from external events.
•Liquidity Risk. Liquidity risk is the risk to our earnings and capital arising from an inability to meet our
cash obligations in a timely manner.
We also are subject to a number of other risks that could adversely impact our business, financial condition,
results of operations and cash flows, including legal and reputational risks that may arise due to a failure to
comply with laws, regulations or ethical standards and codes of conduct applicable to our business activities
and functions.
Effective management of risks is an integral part of our business and critical to our safety and soundness. In
the following sections, we provide an overview of our corporate risk governance structure and risk
management processes, which are intended to identify, measure, monitor and manage the principal risks we
assume in conducting our business activities in accordance with defined policies and procedures. Following the
overview, we provide additional information on how we manage each of our four major categories of risk. In
“Item 1A—Risk Factors,” we identify other risk factors that may adversely affect our business.
Risk Governance Structure
We made significant organizational changes in 2005 and 2006 to enhance our risk governance structure and
strengthen our internal controls due to identified material weaknesses. During 2005, we adopted an enhanced
corporate risk framework to address weaknesses in our risk governance structure. This new framework is
intended to ensure that people and processes are organized in a way that promotes a cross-functional approach
to risk management and controls are in place to better manage our risks. Basic tenets of our corporate risk
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