Fannie Mae 2005 Annual Report Download - page 24

borrowers are more likely to refinance their mortgages. Refinancings could result in prepaid loans being
replaced with new investments in lower interest rate loans and, consequently, a decrease in future interest
income earned on our mortgage assets. At the same time, we may not be able to redeem or repay a sufficient
portion of our existing debt to lower our interest expense by the same amount, which may reduce our net
interest yield.
We strive to maintain low exposure to the risks associated with changes in interest rates. To manage our
exposure to interest rate risk, we engage in the following activities:
•Issuance of Callable and Non-Callable Debt. We issue a broad range of both callable and non-callable
debt securities to manage the duration and prepayment risk of expected cash flows of the mortgage assets
we own.
•Use of Derivative Instruments. While our debt is the primary means by which we manage our interest
rate risk exposure, we supplement our issuance of debt with interest rate-related derivatives to further
manage duration and prepayment risk. We use derivatives in combination with our issuance of debt to
reduce the volatility of the estimated fair value of our mortgage investments. The benefits of derivatives
include:
• the speed and efficiency with which we can alter our risk position; and
• the ability to modify some aspects of our expected cash flows in a specialized manner that might not
be readily achievable with debt instruments.
The use of derivatives also involves costs to our business. Changes in the estimated fair value of these
derivatives impact our net income. Accordingly, our net income will be reduced to the extent that we
incur losses relating to our derivative instruments. In addition, our use of derivatives exposes us to credit
risk relating to our derivative counterparties. We have derivative transaction policies and controls in place
to minimize our derivative counterparty risk. See “Item 7—MD&A—Risk Management—Credit Risk
Management—Institutional Counterparty Credit Risk Management—Derivatives Counterparties” for a
description of our derivative counterparty risk and our policies and controls in place to minimize such
risk. Refer to “Item 1A—Risk Factors” for a description of the risks associated with transactions with our
derivatives counterparties.
•Continuous Monitoring of Our Risk Position. We continuously monitor our risk position and actively
rebalance our portfolio of interest-rate sensitive financial instruments to maintain a close match between
the duration of our assets and liabilities. We use a wide range of risk measures and analytical tools to
assess our exposure to the risks inherent in the asset and liability structure of our business and use these
assessments in the day-to-day management of the mix of our assets and liabilities. If market conditions do
not permit us to fund and manage our investments within our risk parameters, we will not be an active
purchaser of mortgage assets.
For more information regarding our methods for managing interest rate risk and other market risks that impact
our business, refer to “Item 7—MD&A—Risk Management—Interest Rate Risk Management and Other
Market Risks.”
COMPETITION
Our competitors include the Federal Home Loan Mortgage Corporation, referred to as Freddie Mac, the
Federal Home Loan Banks, financial institutions, securities dealers, insurance companies, pension funds and
other investors. Our market share of loans purchased for our investment portfolio or securitized into Fannie
Mae MBS is affected by the amount of residential mortgage loans offered for sale in the secondary market by
loan originators and other market participants, and the amount purchased or securitized by our competitors.
Our market share is also affected by the mix of available mortgage loan products and the credit risk and prices
associated with those loans.
We are an active investor in mortgage-related assets and we compete with a broad range of investors for the
purchase and sale of these assets. Our primary competitors for the purchase and sale of mortgage assets are
19