Fannie Mae 2005 Annual Report Download - page 83

rates increased and these floating-rate assets reset to higher interest rates. The flattening of the yield curve
during 2005 resulted from a significant increase in short-term interest rates due to actions taken by the Federal
Reserve to increase the Federal Funds target interest rate. As of December 31, 2005, the Federal Funds target
rate was 4.25%, 200 basis points higher than at the start of the year and the highest level since 2001. The
impact on long-term interest rates was much smaller, as the yield on the 10-year Treasury ended the year at
4.39%, 17 basis points higher than the end of 2004. Although we significantly reduced the level of our
outstanding short-term debt during 2005, these interest rate changes had the effect of increasing the cost of
short-term debt, which further reduced our net interest income and net interest yield. The increase in the cost
of our long-term debt reflects the replacement of maturing lower-cost debt that we issued during the past few
years to fund our portfolio investments when the yield curve was steep (i.e., short- and medium-term interest
rates were low relative to long-term interest rates). As the yield curve flattened during 2005 and we replaced
this debt to fund our existing fixed-rate mortgage investments, we experienced an increase in our funding
costs. At the same time, we experienced a significant decrease in the periodic net contractual interest expense
accrued on our interest rate swaps during 2005, which is reflected in our consolidated statements of income as
a component of “Derivatives fair value losses, net.”
Net interest income of $18.1 billion for 2004 decreased 7% from $19.5 billion in 2003, driven by a 6%
increase in our average interest-earning assets that was more than offset by a 12% (26 basis points) decline in
our net interest yield to 1.86%. The average yield on our interest-earning assets declined 42 basis points in
2004 to 4.91%, which exceeded the benefit we received from a decrease of 16 basis points in the average cost
of our interest-bearing liabilities to 3.10%. During 2004, our mortgage asset purchases consisted of a greater
proportion of lower-yielding, floating-rate assets. Partially offsetting this reduction in average yield on our
mortgage investments was a slower rate of amortization of premiums in 2004 relative to 2003 due to slower
prepayment rates. The yield on our total average debt decreased in 2004 due to the repurchase and call of a
significant amount of higher cost long-term debt during 2003 and the issuance of new long-term debt at lower
rates. However, as short-term interest rates began to increase in 2004, the cost of our short-term debt began to
rise.
We expect the decrease in the volume of our interest-earning assets and the decline in the spread between the
average yield on these assets and our borrowing costs that we began experiencing at the end of 2004 and that
continued in 2005 to result in further reductions in our net interest income and net interest yield in the near
future.
Guaranty Fee Income
Guaranty fee income primarily consists of contractual guaranty fees related to Fannie Mae MBS held in our
portfolio and held by third-party investors, adjusted for the amortization of upfront fees and impairment of
guaranty assets, net of a proportionate reduction in the related guaranty obligation and deferred profit, and
impairment of buy-ups.
Guaranty fee income is primarily affected by the amount of outstanding Fannie Mae MBS and the
compensation we receive for providing our guaranty on Fannie Mae MBS. The amount of compensation we
receive and the form of payment varies depending on factors such as the risk profile of the securitized loans,
the level of credit risk we assume and the negotiated payment arrangement with the lender. Our payment
arrangements may be in the form of an upfront exchange of payments, an ongoing payment stream from the
cash flows of the MBS trusts, or a combination. We typically negotiate a contractual guaranty fee with the
lender and collect the fee on a monthly basis based on the contractual fee rate multiplied by the unpaid
principal balance of loans underlying a Fannie Mae MBS issuance. In lieu of charging a higher contractual fee
rate for loans with greater credit risk, we may require that the lender pay an upfront fee to compensate us for
assuming the additional credit risk. We refer to this payment as a risk-based pricing adjustment. We also may
adjust the monthly contractual guaranty fee rate so that the pass-through coupon rates on Fannie Mae MBS are
in more easily tradable increments of a whole or half percent by making an upfront payment to the lender
(“buy-up”) or receiving an upfront payment from the lender (“buy-down”).
As we receive monthly contractual payments for our guaranty obligation, we recognize guaranty fee income.
We defer upfront risk-based pricing adjustments and buy-down payments that we receive from lenders and
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