Fannie Mae 2005 Annual Report Download - page 78

Given that a minimal change in any factor listed above that is used for calculation purposes would have a
significant impact to the allowance and reserve liability and these factors have significant interdependencies,
we do not believe a sensitivity analysis isolating one factor is meaningful. Therefore, the following example
illustrates the impact to the allowance and reserve liability given changes to multiple assumptions used for
these factors. For example, a natural disaster, such as a hurricane, might have an adverse impact on net income
and our allowance for loan losses and reserve for guaranty losses. The damage to the properties that serve as
collateral for the mortgages held in our portfolio and the mortgages underlying our mortgage-backed securities
could increase our exposure to credit risk if the damage to the properties is not covered by hazard or flood
insurance. Our estimate of probable credit losses related to a hurricane would involve considerable judgment
and assumptions about the extent of the property damage, the impact on borrower default rates, the value of
the collateral underlying the loans and the amount of insurance recoveries. In the case of Hurricane Katrina in
2005, we preliminarily estimated default rates, severity of loss rates, value of the underlying collateral, and
other potential recoveries. As more information became available, we determined that the property damage
was less extensive than had previously been estimated and the amount of insurance recoveries would be
greater than previously expected. Accordingly, we revised our September 30, 2005 estimate of $257 million
after-tax, which was disclosed in November of 2005, to an estimate of $106 million pre-tax for 2005.
Consolidation—Variable Interest Entities
We are a party to various entities that are considered to be variable interest entities (“VIEs”) as defined in
FASB Interpretation (“FIN”) No. 46 (revised December 2003), Consolidation of Variable Interest Entities (an
interpretation of ARB No. 51) (“FIN 46R”). Generally, a VIE is a corporation, partnership, trust or any other
legal structure that either does not have equity investors with substantive voting rights or has equity investors
that do not provide sufficient financial resources for the entity to support its activities. We invest in securities
issued by VIEs, including Fannie Mae MBS created as part of our securitization program, certain mortgage-
and asset-backed securities that were not issued by us and interests in LIHTC partnerships and other limited
partnerships. Our involvement with a VIE may also include providing a guaranty to the entity.
There is a significant amount of judgment required in interpreting the provisions of FIN 46R and applying
them to specific transactions. FIN 46R indicates that if an entity is a VIE, either a qualitative or a quantitative
assessment may be required to support the conclusion of which party, if any, is the primary beneficiary. The
primary beneficiary is the party that will absorb a majority of the expected losses or a majority of the expected
returns. If the entity is determined to be a VIE, and we either qualitatively or quantitatively determine that we
are the primary beneficiary, we are required to consolidate the assets, liabilities and non-controlling interests
of that entity.
To determine whether we are the primary beneficiary of an entity, we first perform a qualitative analysis,
which requires certain subjective decisions regarding our assessment, including, but not limited to, the design
of the entity, the variability that the entity was designed to create and pass along to its interest holders, the
rights of the parties and the purpose of the arrangement. If we cannot conclude after qualitative analysis
whether we are the primary beneficiary, we perform a quantitative analysis. Quantifying the variability of a
VIE’s assets is complex and subjective, requiring analysis of a significant number of possible future outcomes
as well as the probability of each outcome occurring. The results of each possible outcome are allocated to the
parties holding interests in the VIE and, based on the allocation, a calculation is performed to determine
which, if any, is the primary beneficiary. The analysis is required when we first become involved with the VIE
and on each subsequent date in which there is a reconsideration event (e.g., a purchase of additional beneficial
interests).
We perform qualitative analyses on certain mortgage-backed and asset-backed investment trusts. These
qualitative analyses consider whether the nature of our variable interests exposes us to credit or prepayment
risk, the two primary drivers of expected losses for these VIEs. For those mortgage-backed investment trusts
that we evaluate using quantitative analyses, we use internal models to generate Monte Carlo simulations of
cash flows associated with the different credit, interest rate and housing price environments. Material
assumptions include our projections of interest rates and housing prices, as well as our expectations of
prepayment, default and severity rates. The projection of future cash flows is a subjective process involving
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