Fannie Mae 2005 Annual Report Download - page 148

receive-fixed swaps, partially offset by a reduction in interest rate swaptions. In response to the general
increase in interest rates during the first half of 2006, which lengthened the durations of our mortgage assets,
we generally added to our net pay-fixed swap position. During the second half of the year, when interest rates
generally declined and the durations of our mortgage assets shortened, we added to our net receive-fixed swap
position.
Monitoring and Active Portfolio Rebalancing
Because single-family borrowers typically can prepay a mortgage at any time prior to maturity, the borrower’s
mortgage is economically similar to callable debt. By investing in mortgage assets, we assume this prepayment
risk. As described above, we attempt to offset the prepayment risk and cover our short position either by
issuing callable debt that we can redeem at our option or by purchasing option-based derivatives that we can
exercise at our option. We also manage the prepayment risk of our assets relative to our funding through active
portfolio rebalancing. We develop rebalancing actions based on a number of factors, including an assessment
of key risk measures such as our duration gap and net asset fair value sensitivity, as well as analyses of
additional risk measures and current market conditions.
Measuring Interest Rate Risk
Our Capital Markets group utilizes a wide range of risk measures and analyses to manage the interest rate risk
inherent in the mortgage portfolio. We produce a series of daily, weekly, monthly and quarterly analyses of
interest rate risk measures. Many of our projections of mortgage cash flows in our interest rate risk measures
depend on our internally developed proprietary prepayment models. The models contain many assumptions,
including those regarding borrower behavior in certain interest rate environments and borrower relocation
rates. Other market inputs, such as interest rates, mortgage prices and interest rate volatility, are also critical
components to our interest rate risk measures. The historical patterns that serve as inputs for our models may
not continue in the future. We maintain a research program to constantly evaluate, update and enhance these
assumptions, models and analytical tools as appropriate to reflect our best assessment of the environment.
Our primary interest rate risk measures include duration gap, convexity and net asset fair value sensitivity
measures. On a daily basis, we calculate base duration and convexity gaps as well as the expected change in
the value of our investments for relatively moderate changes in interest rates. On a weekly basis, we also
calculate the expected change in the value of our investments for larger movements in interest rates and other
factors such as implied volatility of option prices. We also perform other standard risk measures on our
portfolio that are based on historical changes in key variables, such as value-at-risk measures and sensitivities
to non-parallel changes in the yield curve.
Duration Gap
The duration gap is a measure of the difference between the estimated durations of our assets and liabilities
(debt and risk management derivatives). Duration gap summarizes the extent to which estimated cash flows for
assets and liabilities are matched, on average, over time and across interest rate scenarios. A positive duration
gap signals a greater exposure to rising interest rates because it indicates that the duration of our assets
exceeds the duration of our liabilities.
Because our duration gap does not incorporate projected future business activity, it is considered a “run-off”
measure of interest rate risk. It reflects our existing mortgage portfolio, including priced asset, debt and
derivatives commitments. We also include the interest rate risk impact of derivative instruments in calculating
the duration of liabilities. Our reported duration gap for periods prior to November 2005 excludes non-
mortgage investments. We began including non-mortgage investments in our duration gap calculation in
November 2005. These incremental assets are primarily short-term, liquid investments included in our liquid
investment portfolio. 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 net
guaranty assets related to changes in interest rates. The fair values of our guaranty assets and guaranty
obligations are presented in Table 17 in “Supplemental Non-GAAP Information—Fair Value Balance Sheet.”
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