Fannie Mae 2005 Annual Report Download - page 77

Table 2: Amortization of Cost Basis Adjustments for Investments in Loans and Securities
2005 2004
For the Year Ended
December 31,
(Dollars in millions)
Unamortized cost basis adjustments. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 344 $ 1,820
Reported net interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,505 18,081
Decrease in net interest income from net amortization . . . . . . . . . . . . . . . . . . . . . . . . . . . (97) (1,221)
Percentage effect on net interest income of change in interest rates:
(1)
100 basis point increase . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.6% 4.5%
50 basis point decrease. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (2.2) (4.9)
(1)
Calculated based on an instantaneous change in interest rates.
As mortgage rates increase, expected prepayment rates generally decrease, which slows the amortization of
cost basis adjustments. Conversely, as mortgage rates decrease, expected prepayment rates generally increase,
which accelerates the amortization of cost basis adjustments.
Allowance for Loan Losses and Reserve for Guaranty Losses
The allowance for loan losses and the reserve for guaranty losses represent our estimate of probable credit
losses arising from loans classified as held for investment in our mortgage portfolio as well as loans that back
mortgage-related securities we guarantee. We use the same methodology to determine our allowance for loan
losses and our reserve for guaranty losses as the relevant factors affecting credit risk are the same. Credit risk
is the risk of loss to future earnings or future cash flows that may result from the failure of a borrower to
make the payments required by his or her mortgage loan. We are exposed to credit risk because we own
mortgage loans and have guaranteed to MBS trusts that we will supplement amounts received by those MBS
trusts as required to permit timely payment of principal and interest on the related Fannie Mae MBS. We
strive to mitigate our credit risk by, among other things, working with lender servicers, monitoring
loan-to-value ratios and requiring mortgage insurance. See “Risk Management—Credit Risk Management”
below for further discussion of how we manage credit risk.
We employ a systematic methodology to determine our best estimate of incurred credit losses. This includes
aggregating homogeneous loans into pools based on similar risk characteristics, using models to measure
historical default and loss experience on the homogeneous loan populations, evaluating larger multifamily
loans individually for impairment, monitoring observable data for key trends, as well as documenting the
results of our estimation process.
Determining the adequacy of the allowance for loan losses and the reserve for guaranty losses is complex and
requires significant judgment by management about the effect of matters that are inherently uncertain. When
appropriate, our methodology involves grouping loans into pools or cohorts based on similar risk characteris-
tics, including origination year, loan-to-value ratio, loan product type and credit rating. We use internally
developed models that consider relevant factors historically affecting loan collectibility, such as default rates,
severity of loss rates and adverse situations that may have occurred affecting the borrowers’ ability to repay.
Management also applies judgment in considering factors that have occurred but are not yet reflected in the
loss factors, such as the estimated value of the underlying collateral, other recoveries and external and
economic factors. The methodology and the amount of our allowance for loan losses and reserve for guaranty
losses are reviewed and approved on a quarterly basis by our Allowance for Loan Loss Oversight Committee,
which is a committee chaired by the Chief Risk Officer or his designee and comprised of senior management
from the Single-Family and HCD businesses, the Chief Risk Office and the finance organization.
We adjust our estimate of the allowance for loan losses and reserve for guaranty losses based on
period-to-period fluctuations in loss experience, economic conditions in areas of geographic concentration and
profile of mortgage characteristics. Using different assumptions about default rates, severity and estimated
deterioration in borrowers’ financial condition than those used in estimating our allowance for loan losses and
reserve for guaranty losses could have a material effect on our net income.
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