Fannie Mae 2005 Annual Report Download - page 145

Management—Institutional Counterparty Credit Risk Management—Derivatives Counterparties.” We use
derivatives for three primary purposes:
(1) As a substitute for notes and bonds that we issue in the debt markets.
When we purchase mortgages, we fund the purchase with a combination of equity and debt. The debt we issue
is a mix that typically consists of short- and long-term, non-callable debt and callable debt. The varied
maturities and flexibility of these debt combinations help us in reducing the mismatch of cash flows between
assets and liabilities.
We can use a mix of debt issuances and derivatives to achieve the same duration matching that would be
achieved by issuing only debt securities. The primary types of derivatives used for this purpose include pay-
fixed and receive-fixed interest rate swaps (used as substitutes for non-callable debt) and pay-fixed and
receive-fixed swaptions (used as substitutes for callable debt).
Below are examples of equivalent funding alternatives for a mortgage purchase with funding derived solely
from debt securities versus funding with a blend of debt securities and derivatives. As illustrated below, we
can achieve similar economic results by funding our mortgage purchases with either debt securities or a
combination of debt securities and derivatives, as follows:
• Rather than issuing a ten-year non-callable fixed-rate note, we could issue short-term debt and enter into a
ten-year interest rate swap with a highly rated counterparty. The derivative counterparty would pay a
floating rate of interest to us on the swap that we would use to pay the interest expense on the short-term
debt, which we would continue to reissue. We would pay the counterparty a fixed rate of interest on the
swap, thus achieving the economics of a ten-year fixed-rate note issue. The combination of the pay-fixed
interest rate swap and short-term debt serves as a substitute for non-callable fixed-rate debt.
• Similarly, instead of issuing a ten-year fixed-rate note callable after three years, we could issue a ten-year
non-callable fixed-rate note and enter into a receive-fixed swaption that would have the same economics
as a ten-year callable note. If we want to call the debt after three years, the swaption would give us the
option to enter into a swap agreement where we would receive a fixed rate of interest from the derivative
counterparty over the remaining seven-year period that would offset the fixed-rate interest payments on
the long-term debt. The combination of the receive-fixed swaption and ten-year non-callable note serves
as a substitute for callable debt.
(2) To achieve risk management objectives not obtainable with debt market securities.
We sometimes have risk management objectives that cannot be fully accomplished by securities generally
available in the debt markets. For example, we can use the derivative markets to purchase swaptions to add
features to our debt not obtainable in the debt markets. Some of the features of the option embedded in a
callable bond are dependent on the market environment at issuance and the par issuance price of the bond.
Thus, in a callable bond we can not specify certain features, such as specifying an “out-of-the-money” option,
which could allow us to more closely match the interest rate risk being hedged. We use option-based
derivatives, such as swaptions, because they provide the added flexibility to fully specify the features of the
option, thereby allowing us to more closely match the interest rate risk being hedged.
(3) To quickly and efficiently rebalance our portfolio.
We seek to keep our assets and liabilities matched within a duration tolerance of plus or minus six months.
When interest rates are volatile, we often need to lengthen or shorten the average duration of our liabilities to
keep them closely matched with our mortgage durations, which change as expected mortgage prepayments
change.
While we have a number of rebalancing tools available to us, it is often most efficient for us to rebalance our
portfolio by adding new derivatives or by terminating existing derivative positions. For example, when interest
rates fall and mortgage durations shorten, we can shorten the duration of our debt by entering into receive-
fixed interest rate swaps that convert longer-duration, fixed-term debt into shorter-duration, floating-rate debt
or by terminating existing pay-fixed interest rate swaps. This use of derivatives helps increase our funding
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