Fannie Mae 2006 Annual Report Download - page 108

with better investment opportunities to purchase mortgage assets because a wider OAS is indicative of
higher expected returns. We generally purchase mortgage assets when mortgage-to-debt OAS is relatively
wide and restrict our purchase activity or sell mortgage assets when mortgage-to-debt OAS is relatively
narrow. We do not, however, attempt to actively manage or hedge the impact of changes in mortgage-to-
debt OAS after we purchase mortgage assets, other than through asset monitoring and disposition.
•Change in the Fair Value of Net Guaranty Assets. As described more fully in “Notes to Consolidated
Financial Statements—Note 19, Fair Value of Financial Instruments,” we calculate the estimated fair value
of our existing guaranty business based on the difference between the estimated fair value of the guaranty
fees we expect to receive and the estimated fair value of the guaranty obligations we assume. The fair
value of both our guaranty assets and our guaranty obligations is highly sensitive to changes in interest
rates and home price assumptions. Changes in interest rates can result in significant periodic fluctuations
in the fair value of our net assets. For example, as interest rates decline, the expected prepayment rate on
fixed-rate mortgages increases, which lowers the fair value of our existing guaranty business. We do not
believe, however, that periodic changes in fair value due to movements in interest rates are the best
indication of the long-term value of our guaranty business because they do not take into account future
guaranty business activity. 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. To assess the value of our underlying guaranty business, we focus primarily on
changes in the fair value of our net guaranty assets resulting from business growth, changes in the credit
quality of existing guaranty arrangements and changes in anticipated future credit performance.
Market Drivers of Changes in Fair Value
Selected relevant market information is shown below in Table 22. Our goal is to minimize the risk associated
with changes in interest rates for our investments in mortgage assets. Accordingly, we do not expect changes
in interest rates to have a significant impact on the fair value of our net mortgage assets. The market
conditions that we expect to have the most significant impact on the fair value of our net assets include
changes in implied volatility and relative changes between mortgage OAS and debt OAS. A decrease in
implied volatility generally increases the estimated fair value of our mortgage assets and decreases the
estimated fair value of our debt and derivatives, while an increase in implied volatility generally has the
opposite effect. A tighter, or lower, mortgage OAS generally increases the estimated fair value of our
mortgage assets, and a tighter debt OAS generally increases the fair value of our liabilities. Changes in interest
rates, however, may have a significant impact on our guaranty business because we do not actively manage or
hedge expected changes in the fair value of our net guaranty assets related to changes in interest rates.
Table 22: Selected Market Information
(1)
2006 2005 2004
2006
vs. 2005
2005
vs. 2004
As of December 31,
Change
10-year U.S. Treasury note yield. . . . . . . . . . . . . . . . . . . . . . . . . . 4.70% 4.39% 4.22% 0.31% 0.17%
Implied volatility
(2)
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15.7% 19.5% 20.1% (3.8)% (0.6)
30-year Fannie Mae MBS par coupon rate . . . . . . . . . . . . . . . . . . . 5.79% 5.75% 5.21% 0.04% 0.54%
Lehman U.S. MBS Index OAS (in basis points) over LIBOR yield
curve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (2.7)bp 4.2bp (11.5)bp (6.9)bp 15.7bp
Lehman U.S. Agency Debt Index OAS (in basis points) over LIBOR
yield curve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (13.8)bp (11.0)bp (6.3)bp (2.8)bp (4.7)bp
House price appreciation
(3)
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9.1% 13.1% 10.7% (4.0)% 2.4%
(1)
Information obtained from Lehman Live, Lehman POINT, Bloomberg and OFHEO.
(2)
Implied volatility for an interest rate swaption with a 3-year option on a 10-year final maturity.
(3)
OFHEO publishes a House Price Index (HPI) quarterly using data provided by Fannie Mae and Freddie Mac. The HPI
is a truncated measure because it is based solely on loans from Fannie Mae and Freddie Mac. As a result, it excludes
loans in excess of conventional loan amounts, or jumbo loans, and includes only a portion of total subprime and Alt-A
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