Fannie Mae 2004 Annual Report Download - page 164

counterparties accounted for between approximately 7% and 14% of the total outstanding notional amount.
Each of the remaining counterparties accounted for less than 5% of the total outstanding notional amount as of
December 31, 2004. In comparison, seven counterparties accounted for approximately 74% of the total
outstanding notional amount as of December 31, 2003. Each of these counterparties accounted for between
approximately 6% and 16% of the total outstanding notional amount, with each of the remaining counter-
parties accounting for less than 5% of the total outstanding notional amount.
Approximately 50% of our net derivatives exposure of $542 million as of December 31, 2004 and 64% of our
net derivatives exposure of $495 million as of December 31, 2003 was with 10 counterparties rated AA- or
better by Standard & Poor’s and Aa3 or better by Moody’s. The percentage of our net exposure with these
counterparties ranged from approximately 0.1% to 13%, or less than $1 million to $70 million as of
December 31, 2004, and from approximately 0.1% to 21%, or less than $1 million to $102 million as of
December 31, 2003.
We mitigate our net exposure on interest rate and foreign currency derivative transactions through a collateral
management policy, which consists of four primary components.
•Minimum Collateral Threshold. Our derivatives counterparties are obligated to post collateral when
exposure to credit losses exceeds agreed-upon thresholds that are based on credit ratings. The amount of
collateral generally must equal the excess of exposure over the threshold amount.
•Collateral Valuation Percentages. We require counterparties to post specific types of collateral to meet
their collateral requirements. The collateral posted by our counterparties as of December 31, 2004
consisted of cash, U.S. Treasury securities, agency debt and agency mortgage-related securities. We assign
each type of collateral a specific valuation percentage based on its relative risk. In cases where the
valuation percentage for a certain type of collateral is less than 100%, we require counterparties to post
an additional amount of collateral to meet their requirements.
•Over-collateralization Based on Low Credit Ratings. We further reduce our net exposure on derivatives
by generally requiring over-collateralization from counterparties whose credit ratings have dropped below
predetermined levels. Counterparties with credit ratings falling below these levels must post collateral
beyond the amounts previously noted to meet their overall requirements.
•Daily Monitoring Procedures. On a daily basis, we value our derivative collateral positions for each
counterparty using both internal and external pricing models, compare the exposure to counterparty limits,
and determine whether additional collateral is required. We evaluate any additional exposure to a
counterparty beyond our model tolerance level based on our corporate credit policy framework for
managing counterparty risk.
Interest Rate Risk Management and Other Market Risks
Our most significant market risks are interest rate risk and spread risk, which arise primarily from the
prepayment uncertainty associated with investing in mortgage-related assets with prepayment options and from
the changing supply and demand for mortgage assets. The majority of our mortgage assets are intermediate-
term or long-term fixed-rate loans that borrowers have the option to pay at any time before the scheduled
maturity date or continue paying until the stated maturity. An inverse relationship exists between changes in
interest rates and the value of fixed-rate investments, including mortgages. As interest rates decline, the value
or price of fixed-rate mortgages held in our portfolio will generally increase because mortgage assets
originated at the prevailing interest rates are likely to have lower yields and prices than the assets we currently
hold in our portfolio. Conversely, an increase in interest rates tends to result in a reduction in the value of our
assets. As interest rates decline prepayment rates tend to increase because more favorable financing is
available to the borrower, which shortens the duration of our mortgage assets. The opposite effect occurs as
interest rates increase.
One way of reducing the interest rate risk associated with investing in long-term, fixed-rate mortgages is to
fund these investments with long-term debt with similar offsetting characteristics. This strategy is complicated
by the fact that most borrowers have the option of prepaying their mortgages at any time, a factor that is
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